## _cr05427

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---

### I. Context and Key Issues
- Policy and structural shift over the last decade:
  - Reduced ratio of gross public debt to GDP below 50 percent.
  - Inflation down to low single-digits within an inflation targeting regime and floating exchange rate.
  - Strengthened public sector balance sheet and financial sector via reforms.
  - Increased integration with world economy, notably fast-growing manufacturing links to the U.S. under NAFTA.
  - Contributed to Mexico’s investment-grade rating, uninterrupted access to foreign capital at low cost, and resilience to shocks such as the 2001–02 world recession.
- Remaining challenges:
  - Fiscal policy lacks a medium-term framework for managing oil wealth and further strengthening the public sector balance sheet.
  - Inflation remains above the central bank’s 3 percent target.
  - Structural reforms needed in energy and telecommunications sectors, labor market, judicial system, tax system, and regulatory/business environment.
  - Political stalemate and constitutional disputes have frustrated reform agenda; presidential and congressional turnover in July 2006.
- 2005 consultation focus areas:
  - Fiscal policy: need for medium-term framework to promote fiscal consolidation and improve oil-wealth management.
  - Monetary policy: evaluate stance after rapid tightening; operational development of inflation targeting.
  - Financial markets: implications of recent reforms and development of credit and bond markets; remaining financial reform agenda.
  - Competitiveness and reforms: raising productivity, competitiveness and growth.
  - Safeguarding confidence and stability in run-up to 2006 election and over medium-term.

### II. Real Sector and Labor Market
- Growth and demand:
  - Growth: 4.4 percent in 2004.
  - Growth slowed to 2.8 percent in the first semester of 2005 (compared to the corresponding semester of 2004).
  - Seasonally-adjusted growth measured relative to previous semester: 1.2 percent (annualized).
  - Slowdown drivers: soft U.S. industrial production, automobile sector re-tooling, lower agricultural yields.
  - Domestic demand moderated; increasing share of demand met by imports.
- Confidence, capacity utilization, employment:
  - Business confidence recovered to pre-recession level by early 2005 but slipped in recent months.
  - Capacity utilization in manufacturing recovered but fell abruptly at mid-2005.
  - Formal employment grew by 4.6 percent from end-2003 to July 2005.
  - Informal employment dominates: economically active population >43 million; 12.8 million employed formally in private sector as of mid-2005.
- Investment:
  - Private investment expenditure: up more than 8 percent in 2004 and by 6 percent in first half of 2005.

### III. Financial Intermediation and Bank Credit Growth
- Post-crisis lending dynamics:
  - Commercial bank lending to private sector resumed and grew rapidly.
  - Consumer and housing bank credit fastest-growing, from a low base.
  - Nonbank financial intermediaries (Sofoles) play important role; Sofoles’ lending close to one third of commercial banks’ financing.
- Drivers of credit growth:
  - Recovery of activity and confidence; disinflation; greater competition; banking reforms; housing guarantees and direct lending programs.
- Risks and implications:
  - Fast credit growth beneficial if supported by adequate risk management.
  - Banks have been writing off 1994–95 crisis NPLs rapidly; stock of total bank financing as share of GDP increased only moderately.
  - Corporate debt and other domestic financing also expanding.
- Selected financing stocks and real percentage changes (stocks in percent of GDP; real percentage change):
  - Total Financing: Dec-03 28.8; Dec-04 28.0; Jun-05 27.6; Dec-03 change 2.6; Dec-04 change 3.0.
  - Foreign Financing: Dec-03 8.4; Dec-04 7.3; Jun-05 6.9; Dec-03 change -8.6; Dec-04 change -6.8.
  - Domestic Financing: Dec-03 20.3; Dec-04 20.7; Jun-05 20.7; Dec-03 change 7.3; Dec-04 change 6.7.
    - Commercial Banks: Dec-03 9.2; Dec-04 9.5; Jun-05 9.8; Dec-03 change 9.6; Dec-04 change 14.7.
    - Development Banks: Dec-03 1.2; Dec-04 0.6; Jun-05 0.6; Dec-03 change -43.2; Dec-04 change -41.9.
    - Non-bank Financial Intermediaries: Dec-03 2.6; Dec-04 3.0; Jun-05 3.1; Dec-03 change 21.6; Dec-04 change 17.3.
    - Debt Issuance: Dec-03 2.1; Dec-04 2.1; Jun-05 1.9; Dec-03 change 5.7; Dec-04 change -6.7.
    - INFONAVIT 1/: Dec-03 5.3; Dec-04 5.4; Jun-05 5.3; Dec-03 change 7.8; Dec-04 change 3.1.
  - Memo: Households: Dec-03 10.6; Dec-04 11.5; Jun-05 12.0; Dec-03 change 14.1; Dec-04 change 14.1.
    - Consumer credit: Dec-03 2.1; Dec-04 2.8; Jun-05 3.2; Dec-03 change 41.3; Dec-04 change 42.0.
    - Mortgage credit: Dec-03 8.5; Dec-04 8.7; Jun-05 8.8; Dec-03 change 7.4; Dec-04 change 6.5.
  - Credit to companies: Dec-03 18.1; Dec-04 16.5; Jun-05 15.6; Dec-03 change -4.2; Dec-04 change -4.2.
  - Foreign Financing (companies): Dec-03 8.4; Dec-04 7.3; Jun-05 6.9; Dec-03 change -8.6; Dec-04 change -6.8.
  - Domestic Financing (companies): Dec-03 9.7; Dec-04 9.2; Jun-05 8.7; Dec-03 change -0.3; Dec-04 change -2.0.
- Note 1/: INFONAVIT = public fund financing housing developers and mortgages with a fixed portion of social security contributions.

### IV. Inflation and Monetary Policy
- Inflation developments:
  - 12-month headline inflation peaked at 5.4 percent in November 2004 and declined thereafter.
  - Headline inflation moved below 4 percent in August 2005.
  - Overall core inflation: 3.3 percent (text indicates core has come down to 3.3 percent).
  - Wage increases steady around 4½ percent.
  - Inflation expectations for end-2006 and next several years average about 3.7 percent as of September; expected inflation somewhat above official 3.0 percent target.
- Monetary policy stance and actions:
  - BoM signaled end to tightening in June 2005 and initiated easing in August 2005.
  - Overnight interbank rate rose from about 5 percent in early 2004 to near 10 percent by spring 2005.
  - In August 2005 BoM announced monetary conditions could ease by up to 25 bp; in September 2005 a further 25 bp cut was signaled, bringing interbank rate down to 9¼ percent (no change in the corto).
  - October 28, 2005: BoM cut overnight interbank rate from 9¼ to 9 percent (third 25 bp easing since end-August 2005); BoM shifting to monthly policy meetings.
- Observations and recommendations:
  - Tighter monetary conditions had not yet dented bank and nonbank credit growth as of 2005.
  - Given policy lags, ending tightening in mid-2005 appropriate; easing should be gradual to entrench credibility gains.
  - Staff suggested extending BoM inflation-forecast communication to a longer horizon or announcing a “convergence horizon.”

### V. Fiscal Developments and Public Debt
- 2004 fiscal outcome:
  - Traditional deficit target achieved: 0.3 percent of GDP.
  - Broadly-defined (augmented) deficit narrowed to 2 percent of GDP, from 3.1 percent in 2003.
  - Current expenditure returned to 2002 level as share of GDP after 2003 rise.
  - Rising oil revenue financed increased capital expenditure, particularly in oil sector.
  - Gross public debt declined to 46.5 percent of GDP (2004), in part through write-off of some bank restructuring debt.
- 2005 fiscal dynamics:
  - Oil revenues rose; spot price averaged US$ 41.6/bl through September, almost US$15 above price assumed in budget.
  - Staff projects oil income up by about ½ percentage point of GDP from 2004 (and about 1 percentage point over budget projections).
  - Under annual budgetary rules, excess oil revenue used to compensate for non-oil revenue shortfalls and for transfers for additional PEMEX and state investment; less than 0.1 percent of GDP available for oil stabilization fund in 2005.
  - Spending composition in 2005 tilted back toward current expenditures; staff projects non-oil augmented deficit will widen in 2005.
- Fiscal sector details:
  - Gasoline excise tax revenue: 1.8 percent of GDP in 2002; 0.7 percent of GDP in 2004; projected 0.2 percent of GDP in 2005.
  - Oil-related revenue increased by almost 2½ percentage points of GDP since 2002; accounted for nearly 40 percent of revenue in 2005.
  - If world price increases had been fully transmitted, government receipts would have increased by a further 1½ percent of GDP.
- 2004 public sector debt (percent of GDP):
  - Federal government 23.3
  - External 8.9
  - Domestic 14.4
  - Public enterprises 1.7
  - Development banks 2.2
  - Gross traditional public sector debt 28.7
  - Adjustments to traditional public sector debt 17.9
  - PIDIREGAS 5.6
  - IPAB 9.6
  - FARAC 2.1
  - Gross augmented public sector debt 46.5
  - Domestic 30.3
  - External 16.2
  - Net augmented public sector debt 41.2
- Fiscal accounting and oil income:
  - Oil windfall revenues in 2005 projected close to 1 percent of GDP; about one third to be transferred for PEMEX and state investment under budget rules.
  - Proposed budget law would set annual budgets balanced at an oil reference price; a zero traditional balance consistent with augmented fiscal deficit of about 1½ percent of GDP and tendency for public debt ratio to decline.

### VI. External Sector and Current Account
- Current account:
  - Annual current account deficit stayed around 1 percent of GDP since 2003.
  - Rise in oil exports and family remittances offset some widening of non-oil trade deficit.
- Remittances:
  - Recorded inbound family remittances increased from about US$6 billion in 1999 to almost US$17 billion in 2004, more than 20 percent annually (partly reflecting improved coverage).
- Pemex oil pricing:
  - Mexican oil mix typically trades US$5–10/barrel below world average (APSP), reducing government windfall relative to other exporters.
- Net International Reserves (NIR):
  - NIR reached US$ 61 billion by end 2004.
  - NIR equivalent to about 4½ months of Mexico’s imports and 1.6 times short-term external liabilities.
  - BoM accumulates NIR mainly from public sector FX cash surplus (including PEMEX) and uses a rules-based mechanism since 2003 to moderate NIR increase by selling a pre-announced portion back into market.
  - At October 28, 2005 NIR was US$62.3 billion.

### VII. Financial Markets, Capital Flows, and Debt Management
- Financial markets:
  - Sovereign bond spreads declined; EMBI+ spread fell below 175 basis points and later to less than 150 basis points.
  - Stock market: up more than 70 percent since end-2003 by end-September; up more than 75 percent by end-October 2005.
  - Peso: gained some 7 percent against the dollar from late April through early August; later shed about 3 points of this gain through end-September.
- Public debt management:
  - Average maturity of federal government domestic debt extended to 3.1 years by June 2005 (from 2.6 years in early 2004 and 1.5 years in 2000).
  - Public sector annual FX earnings from oil now exceed US$ 30 billion, versus interest payments on foreign debt of US$ 9 billion.
  - Authorities announced federal government accumulated enough FX liquidity to forego external bond issues through 2007 (caveats for other public sector parts like PEMEX-related debt).
  - Prefunding included exceptional US$2.9 billion FX purchase from BoM in July 2005.

### VIII. Energy Sector (PEMEX): Reserves, Investment, Governance
- Sector role and figures:
  - After domestic needs met, oil exports ≈ 4 percent of GDP in 2004.
  - About 45 percent of crude production consumed domestically; exports are remainder.
  - Mexican production covers about 90 percent of domestic consumption of refined products and about 80 percent of domestic natural gas use; imports provide balance.
  - PEMEX total sales: US$69 billion in 2004, about 10 percent of GDP.
  - PEMEX accounted for nearly 40 percent of public sector revenue in 2005.
  - Non-oil tax revenue ≈ 10 percent of GDP.
- Investment and reserves:
  - PEMEX investment via PIDIREGAS: average annual US$7 billion in 2000–02 to expected average US$11 billion in 2003–05 (increment ≈ 0.6 percent of annual GDP).
  - Proven oil reserves ≈ 11 years of annual oil production.
  - PEMEX expects reserve replacement ratio to reach 100 percent by 2010 if recent investment rate maintained.
- Governance constraints:
  - PEMEX board comprises government officials and union representatives; lack of clear mandate to maximize value can limit transparency and accountability.
  - Ban on private equity financing forces PEMEX to maintain relatively high debt and prevents government from diversifying assets away from energy exposure.
  - PIDIREGAS: projects executed/financed by private sector then transferred, including associated debt, to public sector.

### IX. Box 2 — Macroeconomic Impacts of Rising Oil Prices and Fiscal Framework
- Macroeconomic impacts:
  - With no private ownership in energy sector, incremental income from higher world oil prices accrues to public sector.
  - Consumers are shielded because domestic gasoline prices are administered and gasoline excise taxes adjusted to smooth prices; gasoline excise revenue fell from 1.8 percent of GDP in 2002 to projected 0.2 percent of GDP in 2005.
  - Electricity subsidies: fiscal cost recently 0.8 percent of GDP.
  - Rising world oil prices may have slightly negative short-term effect on Mexico’s growth because private sector receives no profit income from energy sector.
- Fiscal framework and mission recommendations:
  - Existing framework distributes within-year oil windfalls after compensating for budget shortfalls and non-discretionary overruns; not designed to accumulate multi-year savings.
  - Mission recommended anchoring fiscal policy to a medium-term debt objective and smoothing expenditures over oil cycle via pre-set windfall allocation formulas; staff suggested easing or eliminating preset upper limits on saving (proposed combined funds limit ≈ 1½ percent of GDP).
  - Mission recommended reducing augmented deficit to no more than 1½ percent of GDP in 2006 and avoiding weakening of non-oil balance.
  - Authorities’ draft 2006 budget aimed at small surplus on traditional balance and augmented deficit of 1½ percent of GDP, based on oil price assumption of US$31.5 per barrel (about one-third below prices for Mexican oil mix prevailing in September 2005).

### X. Vulnerabilities, Stress Tests, and Contingency Scenarios
- Overall resilience:
  - Standardized stress tests suggest Mexico resilient to plausible shocks.
  - Worst-case tests (real GDP growth of 1.2 percent or real interest rates of 8 percent average in next four years) keep public debt in 48-50 percent range.
  - Currency depreciation not a serious fiscal risk; fiscal accounts would improve if peso weakened.
  - Broad range of shocks raise gross public sector financing requirement because of relatively short average maturity of domestic debt.
  - Worst projected case: economic stagnation could raise annual public sector financing requirements to 16½ percent of GDP (from about 13 percent in 2005).
- Other stress scenarios:
  - Sudden permanent decline in oil prices (world average US$40/bl from 2006 onwards, implying <US$30/bl for Mexican mix): primary balance deteriorates by about 1 percent of GDP every year if limited spending cuts; gross public debt remains above 45 percent of GDP; financing requirements ≈ 13 percent of GDP.
  - Market-confidence shock (liquidity shock): rapid exchange rate deterioration, hike in interest rates, return to short-term/indexed debt—substantial rise in short-term financing requirements; fiscal deficit not markedly worse initially but liquidity pressures acute.
  - U.S. "hard-landing" scenario: sudden U.S. stagnation, higher Mexican interest rates, some peso appreciation, declining remittances and oil prices—widening fiscal deficit and potential confidence undermining unless fiscal response decisive.
- Baseline public sector gross debt (percent of GDP): 2000 49.3; 2005 45.3; 2006 43.4; 2010 40.1.
- Gross financing need (percent of GDP and US$ billions):
  - 2005: 13.0 percent of GDP; 98.6 in billions of U.S. dollars.
  - Baseline 2006–2010 (percent of GDP): 12.5, 12.4, 11.9, 11.7, 11.4.
  - Baseline 2006–2010 (US$ billions): 103.2, 107.5, 108.9, 112.8, 116.1.
- Selected alternative scenario gross financing needs (public sector, percent of GDP, 2006–2010):
  - A1. Key variables at historical averages: 13.0, 10.5, 8.9, 7.8, 6.9, 6.1.
  - A2. No policy change (constant primary balance): 13.0, 13.4, 13.3, 13.0, 12.9, 12.8.
  - A3. International oil prices at US$40 per barrel: 13.0, 14.2, 13.9, 13.5, 13.2, 12.9.
- External gross external financing need (percent of GDP) under A1 and A2:
  - Baseline 2005: 6.8 percent of GDP.
  - A1 (2006–2010): 6.8, 6.6, 6.3, 5.4, 4.3, 3.1.
  - A2 (falling international oil prices): 6.8, 7.4, 8.6, 8.9, 9.2, 9.6.

### XI. Financial Sector Strengths, Risks, and Policy Recommendations
- Strengths and indicators:
  - Continued improvement in financial sector indicators; strong offsite supervision.
  - Commercial banks adequately capitalized and profitable.
  - Nonperforming loans (NPLs) <2½ percent of total loans (down from 5 percent at end-2001).
  - Provision coverage ≈ 200 percent.
  - Sofoles’ NPLs ≈ 2.7 percent but trending up.
  - Development bank SME guarantee schemes ≈ 0.2 percent of GDP at mid-2005.
- Risks and near-term reform agenda:
  - Continued vigilance and improved efficiency in credit allocation essential.
  - Banks’ exposure to public sector remains high; could crowd out private sector.
  - Near-term reforms: corporate governance improvements, new bank resolution framework, optimal supervision of Sofoles, proposed securities market law to raise corporate governance and encourage equity finance, passage of new bankruptcy law.
  - Authorities to allow Sofoles to branch into leasing and factoring; de-regulate non-deposit-taking Sofoles.
- Pension funds (Afores):
  - Steps considered to promote more diversified investment strategies.
  - Afores still invest heavily in short-duration government instruments and similar portfolios.
  - Each Afore required to establish two mutual funds: one in fixed-income, another in debt and equities; benchmarking being fine-tuned.

### XII. Structural Reforms, Competitiveness, and Growth Outlook
- Competitiveness challenges:
  - Mexico exports almost 90 percent of its goods to the United States.
  - 2004 export volumes no higher than in 1996–98 despite post-NAFTA recovery.
  - Increased competition from China: Mexican and Chinese products compete head on in about one-half of commodities, the value of which equals three-quarters of their total exports to the United States.
  - Survey-based indicators (IMD, WEF) show Mexico below main competitors (China and Canada) and at par with other Latin American countries.
- Structural priorities recommended:
  - Improve supply of skilled labor and modern infrastructure.
  - Address high production costs—especially energy and telecommunications.
  - Improve public and corporate governance.
  - Promote investment to shift resources to higher productivity activities.
- Growth and inflation baseline projections (selected):
  - Real GDP (annual percentage change): 2005 = 3.0; 2006 = 3.5; 2007 = 3.1; 2008 = 3.1; 2009 = 3.1; 2010 = 3.1.
  - Consumer prices (end of year, annual percentage change): 2005 = 3.9; 2006 = 3.4; 2007 = 3.0; 2008 = 3.0; 2009 = 3.0; 2010 = 3.0.
  - Current account balance (percent of GDP): 2005 = -1.1; 2006 = -0.7; 2007 = -1.1; 2008 = -1.3; 2009 = -1.4; 2010 = -1.6.
  - Projection assumes fiscal policy will target and achieve an augmented deficit of about 1 1/2 percent of GDP from 2006.
- Political timing:
  - Major structural reforms unlikely before 2006 elections; potential window for reform in session after elections (September–December 2006).

### XIII. Staff Appraisal and Key Policy Recommendations
- Consolidate macro gains:
  - Entrench progress on public debt structure, financial system strengthening, and anchoring expectations on low inflation.
- Fiscal policy:
  - Orient policymaking toward medium-term objectives; proposed budget law to replace year-to-year decisions with system centered on achieving zero traditional budget deficit over medium-term based on medium-term reference oil price.
  - Press for medium-term objective to further reduce public debt and save revenue gains from oil price booms.
  - Formulate policy considering size of oil reserves and oil-related investment needs.
  - Avoid further deterioration of non-oil augmented balance, including in 2006.
  - Advance reform of public sector pensions and structural tax reform when political consensus allows.
- Public debt management:
  - Continue extending maturity of domestic debt and reduce interest-rate-linked debt to lower rollover and interest-rate risk.
- Monetary policy and communication:
  - Phase out restrictive policy stance at appropriate pace, accounting for election-year risks and gap between private inflation expectations and target.
  - Extend inflation-forecast communication to longer horizon.
- Structural reforms:
  - Resume and advance governance, labor market, energy, telecommunications, and tax reforms to improve competitiveness and sustain higher growth.
- Surveillance recommendation:
  - Next Article IV consultation recommended on standard 12-month cycle.

### XIV. Millennium Development Goals and Social Indicators (selected)
- Goal 1 (Eradicate extreme poverty and hunger):
  - Population below $1 a day (%): 9.9 (latest shown).
  - Prevalence of child malnutrition (% of children under 5): 16.6; 16.9; 7.5.
- Goal 2 (Universal primary education):
  - Net primary enrollment ratio (%): 95.6; 99.5; 99.4.
  - Percentage of cohort reaching grade 5 (%): 79.5; 89.0; 90.5.
- Goal 3 (Gender equality):
  - Ratio girls to boys in primary/secondary education (%): 98.4; 98.2; 101.3.
  - Proportion of seats held by women in national parliament (%): 12.0; 14.0; 18.0; 16.0.
- Goal 4 (Reduce child mortality):
  - Under 5 mortality rate (per 1,000): 44; 36; 30; 25.
  - Infant mortality rate (per 1,000 live births): 37; 30; 25; 23.
- Goal 7 and 8 indicators (selected):
  - Forest area (% of total land area): 32.2; 28.9.
  - Fixed line and mobile telephones (per 1,000 people): 65.6; 101.2; 267.1; 448.8.
  - Personal computers (per 1,000 people): 8.2; 25.6; 57.6; 82.

### XV. Fund Relations, Data Quality, and Technical Assistance
- Fund relations (as of August 31, 2005):
  - Quota: 2,585.80 SDR Million, 100.00% Quota.
  - Fund holdings of currency: 1,954.89 SDR Million, 75.60%.
  - Reserve position: 630.96 SDR Million, 24.40%.
  - SDR Department net cumulative allocation: 290.02 SDR Million, 100.00%; holdings 308.04 SDR Million, 106.21%.
  - Outstanding Purchases and Loans: None.
  - Latest arrangements: Stand-by approvals in 1999 and 1995; EFF approval May 26, 1989.
- Projected payments to Fund (forthcoming): Charges / Interest each year 2005–2009 = 0.02 (no principal).
- Exchange rate arrangement: floating since December 22, 1994; system free of restrictions on current payments and transfers.
- Statistical issues:
  - Core statistical data timely and of good quality; Mexico observes SDDS.
  - Areas for improvement: full transition to BPM5 for some series; IIP yearly; national accounts base year update and input-output table for 2003; fiscal data timeliness and coverage.
- Technical assistance noted: National Accounts Mission STA May 2005; Payments Systems MFD December 2004.

*Source: _cr05427 — IMF staff report content as provided in the supplied PDF excerpt.*

### 1. Selected Economic, Financial, and Social Indicators, 1998–2006 ..............................31

### 1. Selected Economic, Financial, and Social Indicators, 1998–2006 ..............................31

### I. Context and Key Issues
- A shift in policies and economic structure over the last decade has:
  - Reduced the ratio of gross public debt to GDP below 50 percent.
  - Brought inflation down to the low single-digits within an inflation targeting regime and floating exchange rate.
  - Strengthened the public sector balance sheet and the financial sector through a series of reforms.
  - Increased integration with the world economy, notably fast-growing manufacturing links to the U.S. under NAFTA.
  - Contributed to Mexico’s investment-grade rating, uninterrupted access to foreign capital at low cost, and resilience to shocks such as the 2001–02 world recession.
- Remaining challenges:
  - Fiscal policy has broad credibility in meeting annual targets but lacks a medium-term framework for managing oil wealth and further strengthening the public sector balance sheet.
  - Inflation has declined but remains above the central bank’s 3 percent target.
  - Structural reforms are needed to transition to high growth; reforms identified include the energy and telecommunications sectors, the labor market, judicial system, tax system, and regulatory/business environment.
  - Political stalemate and constitutional disputes have frustrated many elements of the Fox administration’s reform agenda; the country is preparing for July 2006 elections that will turn over the presidency and all seats in congress.
- Focus of the 2005 consultation discussions:
  - Fiscal policy: the need for a medium-term framework to promote fiscal consolidation and improve management of oil wealth.
  - Monetary policy: evaluation of the policy stance following rapid tightening, and operational development of the inflation targeting framework.
  - Financial markets: implications of significant recent reforms and development of credit and bond markets, and the remaining financial reform agenda.
  - Competitiveness and reforms: challenges to raise productivity, competitiveness and growth.
  - Safeguarding confidence and stability in the run-up to the 2006 election and over the medium-term.

### II. Recent Developments — Real Sector and Labor Market
- Growth and demand:
  - Economic recovery that began in mid-2003 continued into 2005 but at a substantially slower pace.
  - Growth was 4.4 percent in 2004.
  - Growth slowed to 2.8 percent in the first semester of 2005 (compared to the corresponding semester of 2004). Measured relative to the previous semester, seasonally-adjusted growth was 1.2 percent (on an annualized basis).
  - Slowdown reflected sector-specific developments: a soft patch in U.S. industrial production, re-tooling in the automobile sector, and lower agricultural yields.
  - Domestic demand moderated and an increasing share of demand fell on imports rather than domestic production.
- Confidence, capacity utilization, employment:
  - Business confidence recovered to its pre-recession level by early 2005 but has slipped in recent months.
  - Capacity utilization in manufacturing recovered but fell abruptly at mid-2005.
  - Formal employment grew by 4.6 percent from end-2003 to July 2005.
  - Labor market remains dominated by informal employment: out of the economically active population of more than 43 million, only 12.8 million persons were employed formally in the private sector as of mid-2005.
- Investment:
  - Private investment expenditure was up more than 8 percent in 2004 and by 6 percent in the first half of 2005.

### III. Financial Intermediation and Bank Credit Growth (Box 1)
- Post-crisis lending:
  - Following years of contraction, commercial bank lending to the private sector resumed growing—and at a fast pace.
  - Consumer and housing bank credit showed the fastest rates of growth, but from a very low base.
  - Nonbank financial intermediaries (Sofoles) continue to play an important role in these markets, though bank lending is catching up.
- Drivers of credit growth:
  - Recovery of activity and confidence.
  - Continuing disinflation.
  - Greater competition in the financial sector.
  - Banking reforms which strengthened balance sheets and improved tools to assess creditworthiness and enforce collateral.
  - In housing, government guarantees and direct lending programs leading to conforming mortgages.
- Risks and implications:
  - Fast credit growth will enhance financial intermediation and growth-promoting role if based on adequate risk management frameworks.
  - Banks have been writing off non-performing loans from the 1994–95 crisis at a fast pace, so the stock of total bank financing as a share of GDP has increased only moderately.
  - Corporate debt and other domestic sources of financing are also expanding.
  - Mortgage Sofoles are the most important type; Sofoles’ lending is now close to a third of commercial banks’ financing.
- Table 1 (selected figures, stocks in percent of GDP; real percentage change):
  - Total Financing: Dec-03 28.8; Dec-04 28.0; Jun-05 27.6; Dec-03 change 2.6; Dec-04 change 3.0.
  - Foreign Financing: Dec-03 8.4; Dec-04 7.3; Jun-05 6.9; Dec-03 change -8.6; Dec-04 change -6.8.
  - Domestic Financing: Dec-03 20.3; Dec-04 20.7; Jun-05 20.7; Dec-03 change 7.3; Dec-04 change 6.7.
    - Commercial Banks: Dec-03 9.2; Dec-04 9.5; Jun-05 9.8; Dec-03 change 9.6; Dec-04 change 14.7.
    - Development Banks: Dec-03 1.2; Dec-04 0.6; Jun-05 0.6; Dec-03 change -43.2; Dec-04 change -41.9.
    - Non-bank Financial Intermediaries: Dec-03 2.6; Dec-04 3.0; Jun-05 3.1; Dec-03 change 21.6; Dec-04 change 17.3.
    - Debt Issuance: Dec-03 2.1; Dec-04 2.1; Jun-05 1.9; Dec-03 change 5.7; Dec-04 change -6.7.
    - INFONAVIT 1/: Dec-03 5.3; Dec-04 5.4; Jun-05 5.3; Dec-03 change 7.8; Dec-04 change 3.1.
  - Memo: Households: Dec-03 10.6; Dec-04 11.5; Jun-05 12.0; Dec-03 change 14.1; Dec-04 change 14.1.
    - Consumer credit: Dec-03 2.1; Dec-04 2.8; Jun-05 3.2; Dec-03 change 41.3; Dec-04 change 42.0.
    - Mortgage credit: Dec-03 8.5; Dec-04 8.7; Jun-05 8.8; Dec-03 change 7.4; Dec-04 change 6.5.
  - Credit to companies: Dec-03 18.1; Dec-04 16.5; Jun-05 15.6; Dec-03 change -4.2; Dec-04 change -4.2.
  - Foreign Financing (companies): Dec-03 8.4; Dec-04 7.3; Jun-05 6.9; Dec-03 change -8.6; Dec-04 change -6.8.
  - Domestic Financing (companies): Dec-03 9.7; Dec-04 9.2; Jun-05 8.7; Dec-03 change -0.3; Dec-04 change -2.0.
  - Note 1/: INFONAVIT is a public fund financing housing developers and mortgages with a fixed portion of social security contributions.

### IV. Inflation and Monetary Policy
- Inflation developments:
  - The 12-month headline inflation rate peaked at 5.4 percent in November 2004 and declined thereafter with the unwinding of supply shocks and moderation of core inflation.
  - Headline inflation moved below 4 percent in August 2005.
  - Overall core inflation has come down to 3.3 percent.
  - Wage increases have been steady at around 4½ percent.
  - Inflation expectations for end-2006 and for the next several years average about 3.7 percent as of September; expected inflation remains somewhat above the official inflation target.
  - The authorities emphasize the inflation target is 3.0 percent; expected inflation is within a 2–4 percent variability range but still above the target.
- Monetary policy stance:
  - The Bank of Mexico (BoM) signaled an end to its monetary tightening cycle in June 2005 and initiated easing in August 2005.
  - Policy tightening entailed the overnight interbank interest rate rising from about 5 percent in early 2004 to near 10 percent by spring 2005.
  - From May 2004 the BoM enhanced communication, signaling desired minimum levels of interest rates and linking short statements to policy movements; in June 2005 the BoM dropped the explicit link to the U.S. Fed Funds rate and emphasized maintaining the present monetary stance.
  - In August 2005 the BoM announced monetary conditions could ease by up to 25 bp (without changing the corto).
  - In September 2005 a further 25 basis point cut was signaled, bringing the interbank rate down to 9¼ percent (still with no change in the corto).
- Observations:
  - Tighter monetary conditions had not yet dented the growth of bank and nonbank credit as of 2005.
  - Core goods inflation had accelerated in 2004; both headline and core inflation remained above the BoM’s 3 percent target though edged down.

### V. Fiscal Developments
- 2004 fiscal outcome:
  - Traditional deficit target achieved: 0.3 percent of GDP.
  - The broadly-defined deficit (augmented deficit) narrowed to 2 percent of GDP, from 3.1 percent in 2003.
  - Current expenditure returned to its 2002 level as a share of GDP after rising in 2003.
  - Rising oil revenue financed an increase in capital expenditure, particularly in the oil sector.
  - The 2004 augmented deficit outcome partly reflected a “temporary saving” from oil revenues: 0.4 percent of GDP of funds earmarked for additional PEMEX investment were not yet spent in 2004.
  - Gross public debt declined to 46.5 percent of GDP, in part through the write-off of some bank restructuring debt.
- 2005 fiscal dynamics:
  - Oil revenues are rising again in 2005 but the impact on the broader deficit is more than offset by a deterioration in the non-oil fiscal balance.
  - The spot price of Mexican oil averaged US$ 41.6/bl through September, almost 15 dollars above the price assumed in the budget.
  - Staff projects oil income for the year to be up by about ½ percentage point of GDP from 2004 (and about 1 percentage point over budget projections).
  - Under annual budgetary rules, excess oil revenue appears to be used to compensate for shortfalls in non-oil revenue and toward transfers for additional investment spending by PEMEX and the states, as implied by the budget law.
  - Less than 0.1 percent of GDP will be available to be sent to the oil stabilization fund in 2005.
  - In contrast to 2004, spending composition in 2005 appears to have tilted back toward current expenditures.
  - Staff projects the non-oil augmented deficit will widen in 2005.

*Source: _cr05427 - 1. Selected Economic, Financial, and Social Indicators, 1998–2006 ..............................31*

### 0.8 percent of GDP.

### _cr05427 - 0.8 percent of GDP.

### Fiscal sector: revenue, deficits, and public debt
- Gasoline pricing policy moderated oil revenue gains; gasoline “at the pump” prices increased only in line with domestic inflation as a gasoline excise tax was steadily reduced.
- Gasoline excise tax revenue: from 1.8 percent of GDP in 2002 to 0.7 percent of GDP in 2004, and projected 0.2 percent of GDP this year.
- Rapid growth in oil revenue since 2002 offset a decline in non-oil revenue.
- Oil-related revenue increased by almost 2½ percentage points of GDP since 2002 and accounted for nearly 40 percent of revenue in 2005.
- If world market price increases had been fully transmitted to domestic consumers, government receipts would have increased by a further 1½ percent of GDP (instead of being offset by excise tax reductions).
- Augmented fiscal balance developments (percent of GDP):
  - Augmented balance narrowed since 2000, largely reflecting lower interest costs.
  - From 2002 to 2005: overall augmented deficit reduced by about 1 percent of GDP; non-oil augmented deficit widened by about 1¼ percent of GDP.
- 2004 public sector debt (percent of GDP):
  - Federal government 23.3
  - External 8.9
  - Domestic 14.4
  - Public enterprises 1.7
  - Development banks 2.2
  - Gross traditional public sector debt 28.7
  - Adjustments to traditional public sector debt 17.9
  - PIDIREGAS 5.6
  - IPAB 9.6
  - FARAC 2.1
  - Gross augmented public sector debt 46.5
  - Domestic 30.3
  - External 16.2
  - Net augmented public sector debt 41.2
- Fiscal accounting and oil income:
  - Oil windfall revenues in 2005 projected close to 1 percent of GDP; about one third to be transferred for investment projects by PEMEX and the states under budget rules.
  - The proposed budget law in congress would set annual budgets balanced at an oil reference price; a zero traditional balance would be consistent with an augmented fiscal deficit of about 1½ percent of GDP and a tendency for the public debt ratio to decline.

### External sector and current account
- External current account broadly stable recently; continued rise in oil exports and household remittances offset some widening of the non-oil trade deficit.
- Since 2003, the annual current account deficit stayed around 1 percent of GDP.
- Recorded inbound family remittances increased from about US$6 billion in 1999 to almost US$17 billion in 2004, more than 20 percent annually (partly reflecting improved statistical coverage).
- Pemex average oil price trended with world oil prices; Mexican oil mix tends to trade some US$5–10/barrel below the world average (APSP).
- Non-oil exports have lagged imports recently; weak auto exports to the U.S. and enhanced competition from China slowed non-oil exports.
- Net International Reserves (NIR) developments:
  - NIR reached US$ 61 billion by end 2004.
  - NIR equivalent to about 4½ months of Mexico’s imports and 1.6 times its short-term external liabilities.
  - BoM accumulates NIR mainly from a public sector foreign exchange cash surplus (including PEMEX) and uses a rules-based mechanism since 2003 to moderate the rate of NIR increase by selling a pre-announced portion back into the market.

### Financial markets and capital flows
- Mexican financial markets strengthened with other emerging markets:
  - Sovereign bond spreads declined; Mexico's EMBI+ spread fell below 175 basis points.
  - At end-September, the stock market was up more than 70 percent (in domestic currency terms) since end-2003.
  - From late April through early August, the peso gained some 7 percent against the dollar (the peso later shed about 3 points of this gain through end-September).
- Interest rates and yields:
  - Average maturity of federal government domestic debt extended to 3.1 years by June 2005 (from 2.6 years in early 2004 and 1.5 years in 2000).
  - Public sector annual foreign exchange earnings from oil now exceed US$ 30 billion, against interest payments on foreign debt of US$ 9 billion.
- Recent private capital inflows (in billions of U.S. dollars) show portfolio inflows, bonds, short-term inflows, banks, and nonbanks movements (series presented in the source).

### Outlook and risks
- Growth projections:
  - Staff project GDP growth of about 3 percent in 2005, picking up to 3½ percent in 2006.
  - Authorities projected somewhat higher 2005 growth.
  - Medium-term authority projection 3.6 percent versus staff 3.1 percent.
- Inflation projections:
  - Inflation expected to end 2005 at somewhat below 4 percent, decline to about 3½ percent at end-2006, and 3 percent in 2007.
  - Projection assumes no new substantial supply shocks and BoM policy focused on achieving the 3 percent target.
- Key near-term uncertainties:
  - Developments in the U.S. economy, global liquidity conditions, and possible shifts in confidence.
  - A moderate slowdown in the U.S. would affect Mexico via exports, confidence, and FDI.
  - Sectoral risks, including performance of new auto models manufactured in Mexico for the U.S. market.
  - Political risks that could undermine confidence in macroeconomic discipline.

### Public debt management and vulnerability reduction
- Authorities took steps to reduce public debt vulnerabilities:
  - Extended average maturity of domestic federal debt to 3.1 years by June 2005.
  - Reduced exposure to currency depreciation as public sector annual foreign exchange earnings from oil exceed US$ 30 billion.
  - Used the oil stabilization fund to hedge government external oil revenue for 2005.
  - Announced federal government accumulated enough foreign currency liquidity to forego external bond issues through 2007 (with caveats regarding other public sector parts like PEMEX-related debt).
  - Part of prefunding included an exceptional US$2.9 billion purchase of foreign exchange from the BoM in July 2005.

### Energy sector (Box 2): PEMEX, reserves, and governance
- Energy sector characteristics:
  - After domestic needs met, oil exports represented about 4 percent of GDP in 2004.
  - Of crude oil production, about 45 percent is consumed domestically; exports constitute the remainder.
  - Mexican production covers about 90 percent of domestic consumption of refined oil products and about 80 percent of domestic natural gas use; imports provide the balance.
  - Mexican oil mix is mainly heavy crude and typically trades some US$5–10/barrel below world average (APSP), reducing Mexico’s “oil windfall” gains relative to other exporters.
- PEMEX significance and figures:
  - PEMEX total sales reached US$69 billion in 2004, about 10 percent of GDP.
  - PEMEX accounted for a critical share of public sector revenue, reaching nearly 40 percent in 2005.
  - Non-oil tax revenue in Mexico is relatively small, about 10 percent of GDP.
- Investment and reserves:
  - PEMEX investment rose via PIDIREGAS: from an average annual US$7 billion in 2000–02 to an expected average US$11 billion in 2003–05 (increment of about 0.6 percent of annual GDP).
  - Proven oil reserves are equivalent to about 11 years of annual oil production.
  - PEMEX expects the reserve replacement ratio to reach 100 percent by 2010 if recent investment rate is maintained.
- Governance and constraints:
  - PEMEX board comprises government officials and union representatives; absence of a clear mandate to maximize value can limit transparency and accountability.
  - Ban on private equity financing forces PEMEX to have relatively high debt and prevents the government from diversifying assets away from energy-sector exposure.
  - PIDIREGAS: infrastructure projects first executed and financed by the private sector and later transferred, as well as the debt associated to them, to the public sector.

*Source: _cr05427 - 0.8 percent of GDP.*

### Box 2. The Mexican Energy Sector Amid Rising Fuel Prices (continued)

### Box 2. The Mexican Energy Sector Amid Rising Fuel Prices (continued)

### Macroeconomic impacts of rising oil prices
- With no private ownership in the Mexican energy sector, when world oil prices rise, all incremental income accrues to the public sector.
- From a macroeconomic viewpoint, an increase in world oil prices could be thought of as an increase in a tax on consumption of oil, but this effect is largely offset in Mexico, as consumers are shielded from rising world prices.
- The government’s oil windfall (based on all sales, domestic and foreign) exceeds the nation’s windfall (which arises only from exports).
- The government’s windfall is dampened because gasoline excise taxes are adjusted to smooth the price paid by domestic consumers; domestic gasoline prices are administered, generally set to rise at a rate similar to that of inflation.
  - Revenue from the gasoline excise fell from 1.8 percent of GDP in 2002 to a projected 0.2 percent of GDP in 2005.
  - Most consumers receive electricity at a subsidized price, with a fiscal cost of 0.8 percent of GDP recently.
- In terms of short-term economic growth, rising oil prices may be expected to have a slightly negative effect in Mexico because the Mexican private sector receives no profit income from the energy sector.
- Much of the potential drag on domestic demand from higher prices has either been avoided (by not passing price increases to consumers) or has been offset by a deterioration of the non-oil fiscal balance.
- The most relevant channel on growth is through higher oil prices’ potential negative impact on the U.S. economy, in turn affecting Mexican exports.

### Fiscal framework for oil income fluctuations
- The fiscal framework for oil income has taken a year-at-a-time approach, centered on distributing the within-year oil windfall (excess oil income defined relative to the budget’s assumptions).
- Advantages and features of the conservative budget assumption:
  - Avoids the need to cut budgeted expenditures if the oil price declines unexpectedly during the budget year.
  - May help contain the growth of recurrent expenditure programs that would add inertia to government expenditure.
- Each year’s budget law specifies a formula for distributing any oil windfall, but the windfall is measured after first compensating for shortfalls in budget revenues and financing overruns in certain non-discretionary spending (including spending arrears from the previous year, higher interest payments, and higher energy costs).
- Consequences of the current approach:
  - Consistent with achievement of annual targets for the traditional budget deficit.
  - Saving of incremental oil income since 2002, as measured by the narrowing of the augmented fiscal deficit, has been limited for several reasons:
    - “Excess” oil income is defined relative to an annual budget assumption that has been raised over time.
    - Excess income is defined net of certain negative developments elsewhere in the budget.
    - Budget adjustor formulas agreed each year assure that an important fraction of the remaining windfall will be spent.
  - The framework is not designed to achieve financial savings of temporary income from a multi-year oil price boom, but rather to support compliance with annual deficit targets.
- Proposed changes and mission recommendations:
  - Proposal to smooth expenditures over the oil cycle by allocating windfalls according to a pre-set formula, reducing leakages where unbudgeted windfall income is measured net of negative budget developments.
  - Mission recommended anchoring fiscal policy by linking the framework to a medium-term debt objective; authorities were concerned that proposing a specific debt target could complicate congressional approval but expected the proposed deficit target to be consistent with a gradual decline in the public debt ratio.
  - Staff observed that the new approach would put rather low upper limits on saving: three saving funds would be established, but once these reached certain levels (about 1½ percent of GDP, for the combined funds), all subsequent oil windfall money would go to expenditure; mission suggested easing or eliminating these limits on saving, but authorities felt consensus for greater saving was not yet established.
  - The saving funds would provide an important cushion and the proposed framework was symmetric: during times of low oil prices, dissaving would also be limited.
- 2006 budget and staff recommendations:
  - Mission supported authorities’ intention to maintain consolidation efforts and increase saving of oil revenue.
  - Mission recommended reducing the augmented deficit to no more than 1½ percent of GDP in 2006, and in any case to avoid a weakening of the non-oil balance.
  - Authorities’ draft 2006 budget aimed at a small surplus on the traditional balance, and an augmented deficit of 1½ percent of GDP, based on general expenditure restraint and an oil price assumption of US$31.5 per barrel.
    - Note: US$31.5 per barrel was about one-third below prices for the Mexican oil mix prevailing in September 2005.
  - Should oil prices turn out higher than the budget’s assumption, the outcome for the underlying fiscal stance—as indicated by the non-oil augmented balance—would again depend on the budget’s procedures for allocating unbudgeted oil income.
  - Staff project that the non-oil deficit would stay essentially constant in 2006 (this projection is based on a cut in the expenditure ratio from 2005, although not as large as the decline in the budget proposal).

### Monetary and Exchange Rate Policy
- Policy objectives and recent stance:
  - Tightening of monetary conditions in 2004 and 2005 was necessary to contain, and then reduce, inflation.
  - Authorities aimed to take inflation down to the 3 percent target and did not accept a settling of inflation in the upper part of the 2–4 percent “variability range”.
- Effects of tightening:
  - Tightened stance prevented spillovers of temporary price shocks and helped further convergence of inflation to its target.
  - Wage increases had not accelerated, and inflation expectations had been revised downward; by mid-2005 both core inflation and inflation expectations had eased.
- Appropriate timing and pace of easing:
  - It was appropriate to end the monetary tightening cycle in mid-2005.
  - Tightening had taken short-term real interest rates up to around 6 percent, and some effect on demand was still in the pipeline.
  - Given restrictiveness and monetary policy lags, it would be natural to begin relaxing the stance ahead of actually achieving the 3 percent target, but easing should be gradual and cautious to entrench credibility gains.
- Operational and communication issues:
  - Authorities have shortened policy announcements to a single page, emphasized the central bank’s target is 3 percent (not the 2–4 percent variability range), and guided more explicitly the evolution of short-term interest rates.
  - Monetary conditions and policy are increasingly conceived in terms of the overnight interest rate; authorities remain comfortable with continued use of the corto as the official policy instrument and did not see a clear case to shift now to an explicit interest rate target.
  - In August and September communiqués the central bank signaled that interest rates could fall, but did not change the corto.
  - Staff suggested that moving to a single instrument would provide more clarity to markets.
- Managing inflation expectations:
  - Persistence of private inflation expectations above the official inflation target at all horizons raises the question of further enhancements.
  - Mission welcomed BoM public projection of near-term inflation and suggested publishing a forecast corresponding to a conventional monetary policy horizon or announcing a “convergence horizon” to help manage private expectations; authorities considered potential benefits but felt risks to flexibility and credibility remained until final disinflation step is achieved.
- Exchange rate and reserves:
  - Mexico continues to be well-served by its floating exchange rate regime.
  - Mission commended adherence to a floating exchange rate regime accompanied by a rules-based reserve accumulation policy; the rule’s formula for selling back reserves is transparent and avoids suggesting an exchange rate target.
  - Staff believed the level of reserves was reasonably healthy; further accumulation was not problematic and could support confidence in an election year context.
  - Authorities noted the “carrying” cost of reserves had climbed with the widening Mexico-U.S. interest differential but viewed this as temporary and already being reversed.

### Financial Sector Issues and Policies
- Overall assessment and improvements:
  - Continued improvement of a wide set of financial sector indicators.
  - Strong offsite supervision of risk management practices of commercial banks and the largest nonbank financial intermediaries (the mortgage Sofoles).
  - Increased reliance on market discipline mechanisms and growing participation of institutional investors with large assets under management.
  - Commercial banks are adequately capitalized, profitable, and appear to have sound risk management systems.
- Key statistics and indicators:
  - Nonperforming bank loans (NPLs) are relatively low at less than 2½ percent of total loans, down from 5 percent at end 2001.
  - Banks have built sizeable provisions against NPLs, with coverage ratios around 200 percent.
  - Recent stress tests show commercial banks would withstand severe market and private credit risk shocks.
  - Guarantee schemes targeted to SMEs through development banks support credit growth but are still limited in size (around 0.2 percent of GDP at mid-2005).
  - Sofoles’ non-performing loans remain low (about 2.7 percent of total loans) but have shown an upward trend in the year.
- Risks and recommended vigilance:
  - Continued vigilance and increased efficiency in allocation of credit to the private sector remain essential.
  - Commercial banks’ exposure to the public sector, although stable, remains high; such claims can make banks sensitive to potential changes in the value of government securities and can crowd out the private sector.
- Near-term reform agenda:
  - Corporate governance improvements, new bank resolution framework, and optimal supervision of Sofoles.
  - Proposed securities market law aims at raising corporate governance standards and encouraging smaller firms to use equity finance by strengthening minority shareholder rights (submission to congress has met intense counter-lobbying).
  - Government in final stage of preparing new bank resolution legislation; passage of a new bankruptcy law would eliminate loopholes that complicate resolution of financial institutions.
  - Authorities plan to allow Sofoles to branch into leasing and factoring, de-regulating those Sofoles that do not take deposits.
- Pension fund (Afores) issues:
  - Authorities considering steps to promote more diversified investment strategies among Afores.
  - Although regulations have been changed to allow greater diversification, Afores continue to invest heavily in mostly short-duration government instruments and in very similar portfolios.
  - To lessen investment concentration, each Afore has had to establish two mutual funds: one entirely in fixed-income securities, and another in debt securities and equities; authorities are fine-tuning this “benchmarking” in coordination with the industry.
- Reform track record:
  - Mexico’s track record in financial reforms is welcomed; many 2001 FSAP recommendations have been addressed, including payments system, banking regulation, and offsite supervision.
  - Authorities plan to request an FSAP update soon.

### Vulnerabilities and Measures to Boost Resilience
- Authorities underscored that economic fundamentals are solid and resilience to shocks has been fortified.
- Public debt and debt profile:
  - Level of gross public sector debt is around 45 percent of GDP and does not raise concerns of sustainability.
  - Current fiscal stance is already adequate to avoid a rise in this debt ratio.
  - Average maturity of domestic debt has increased in recent years.
  - Government has shunned dollar-indexed debt and shifted away from external debt; as oil export prices have risen, there is no longer concern about the budget’s net exposure to peso depreciation.
  - External debt is mainly long-term, and the authorities consider that the federal government will not need to issue in the global bond market before 2007.

*Source: IMF staff report excerpt, “Box 2. The Mexican Energy Sector Amid Rising Fuel Prices (continued).”*

### 41.       Staff agreed that Mexico’s economy has been considerably strengthened. The

### _cr05427 - 41.       Staff agreed that Mexico’s economy has been considerably strengthened. The

### Macroeconomic strengths and external position
- Exchange rate regime: flexible.
- Inflation framework: commitment to low inflation is credible; inflation targeting with a 3 percent target.
- Exchange rate pass-through to inflation: low.
- Public and external balance-sheet strengths:
  - External debt and external financing needs of both public and private sectors are smaller in Mexico than in many other countries.
  - Modest current account deficit has been more than covered by FDI.
- Selected vulnerability indicators, 2004 (Mexico vs. Median, sample of 48 emerging market countries):
  - Gross reserves in percent of short-term debt at remaining maturity: 136.4 148.1
  - Total gross external debt: 23.5 46.8
  - Of which: External debt of domestic private sector: 8.5 22.9
  - Current account balance: -1.1 -0.9
  - Gross external financing requirement 1/: 6.8 12.5
  - Public sector overall balance: -2.0 -2.2
  - Gross public sector financing requirement 3/: 13.0 7.6
  - Public sector gross debt: 46.5 46.7
  - Of which: Exposed to exchange rate risk 4/: 16.3 25.7
  - Exposed to rollover risk (ST debt, residual maturity) 5/: 10.6 4.4
  - MLT debt at variable interest rate: 14.5 12.3
  - Memo items: EMBI + secondary market spread (bps, average): 187.0...
  - (Source: Staff estimates. Notes 1/–5/ as in source.)

### Fiscal vulnerabilities and public debt structure
- Annual public sector financing needs are estimated to exceed 10 percent of GDP.
- Oil price sensitivity: a decline in the oil price of US$10/bl reduces government revenue by about 1 percent of GDP.
- Public debt and maturity:
  - Average maturity of domestically-issued public debt: 3.1 years at mid-2005.
  - Estimated share of public domestic debt carrying floating interest rate or short-term: 17¾ percent of GDP.
- Policy implications highlighted by staff:
  - Further reduce public sector financing needs by lowering the public debt ratio.
  - Continue extending the average maturity of public debt—especially domestically-issued debt.
  - Reduce rollover risk to avoid sharply higher gross public sector financing needs in the event of sustained shocks.
  - Take account of public sector liquid assets when assessing financing needs (example: IPAB held liquid assets of about 1.5 percent of GDP at mid-2005).

### Shock scenarios and contingency planning
- Confidence-shock scenario (Annex V summary): a hike in interest rates and a sharp depreciation, along with weaker growth, could put public debt on an upward path; the rise would be fairly limited for a short-lived shock, but gross public sector financing needs could rise significantly if the shock were sustained and short-term debt were used to finance amortization.
- External downside scenario: lower U.S. and world growth—especially if prompted by a significant loss of confidence in U.S. assets and rising foreign interest rates—would sharply affect Mexico through:
  - Export links to the U.S.
  - Demand-induced drop in world oil prices.
  - Result: economic activity in Mexico would be strongly affected; in the absence of new fiscal measures, the augmented fiscal deficit could widen by several percentage points of GDP (mainly from oil price and interest rate effects).
- Recommended response: an early and decisive fiscal policy response would be essential in a severe external downturn.

### Structural reforms and competitiveness
- Political context: major structural reforms unlikely before the 2006 elections; a potential window for reform in the parliamentary session immediately after the elections (September–December 2006).
- Ongoing smaller-scale reforms and measures in 2005:
  - Laws for specific sectors (mining and farming) and public procurement approved through a Senate working group on competitiveness.
  - Administrative measures to reduce red tape and enhance tax collections.
  - Regional integration progress (security and prosperity partnership with the U.S. and Canada expected to promote integration).
- PEMEX governance: mission emphasized need to advance reforms of PEMEX corporate governance given higher oil prices and resource flows; administration proposals had not advanced in congress.
- Competitiveness concerns:
  - Mexico exports almost 90 percent of its goods to the United States.
  - Mexico’s share of world export markets returned to post-NAFTA levels, but 2004 export volumes were no higher than in 1996–98.
  - Increased competition from China: Mexican and Chinese products compete head on in about one-half of commodities, the value of which is equivalent to three-quarters of their total exports to the United States (Bank of Mexico data).
  - Structural competitiveness indicators (survey-based):
    - IMD, WEF rankings show Mexico below main competitors (China and Canada) and at par with other Latin American countries.
    - IMD Elements of Competitiveness (2005) components show Mexico scoring much below Canada and Chile in economic performance, government efficiency, business efficiency, and infrastructure, and below China in most categories except business efficiency.
  - Foreign Direct Investment, in percent of GDP (periods shown):
    - Mexico: 1995–1999: 2.9 3.0 2000–2004: 2.9 2003–2004: 2.2
    - Latin America (excl. Mexico) 1/: 3.2 3.6 2.7 2.2
    - New EU member countries 2/: 5.2 4.7 5.6 3.8
    - Selected Southern Europe 3/: 3.5 1.4 5.6 4.0
    - (Source: World Economic Outlook. Notes 1/–3/ as in source.)
- Recommended structural priorities:
  - Improve supply of skilled labor and modern infrastructure.
  - Address high production costs—especially energy and telecommunication.
  - Improve public and corporate governance.
  - Promote investment to shift resources to higher productivity activities as traditional maquila manufacturing moves to lower-wage markets.

### Monetary policy and financial sector
- Monetary policy:
  - Challenge: achieve full credibility of the 3 percent inflation target and align private expectations with the official target.
  - Central bank actions in 2004: acted to ensure a rise in inflation and inflation expectations did not become entrenched; pushed inflation down toward the 3 percent target.
  - Operational framework enhancements since early 2004 improved policy communication, including defining policy changes in terms of an interest rate target and indicating an inflation forecast for the current year.
  - Recommendation: extend the central bank’s inflation forecast communication to a somewhat longer horizon.
- Financial sector:
  - Considerable progress in strengthening the financial sector and supervision; bank credit has begun to expand after many years of stagnation.
  - Authorities intend to request an FSAP update.
  - Ongoing need: financial reform and supervision must continue as a process.

### Staff appraisal: priorities and policy recommendations
- Consolidate macroeconomic gains:
  - Entrench progress on public debt structure, financial system strengthening, and anchoring expectations on low inflation rather than an exchange rate objective.
- Fiscal policy:
  - Orient fiscal policymaking toward medium-term objectives; proposed budget law would replace year-to-year decision-making with a system centered on achieving a zero budget deficit over the medium-term based on a medium-term reference oil price.
  - Press for a medium-term objective of further reducing public debt to save revenue gains from oil price booms.
  - Explicitly formulate policy in light of the size of oil reserves and oil-related investment needs.
  - Avoid further deterioration of the non-oil augmented balance, including in 2006.
  - Advance reform of public sector pensions and a structural tax reform when political consensus allows.
- Public debt management:
  - Keep extending the maturity of all domestic debt and reduce the level of interest rate-linked debt to lower rollover and interest-rate risk.
- Monetary policy and communication:
  - Continue phasing out the restrictive policy stance at an appropriate pace, taking account of election-year risks and the remaining gap between private inflation expectations and the inflation target.
  - Extend inflation-forecast communication to a longer horizon.
- Structural reforms:
  - Resume and advance governance, labor market, energy, telecommunications, and tax reforms as feasible—moves essential to improve competitiveness and sustain higher growth.

*Source: Staff report content as provided.*

### 56.      Mexico is well-served by maintaining its floating exchange rate regime, including

### Mexico is well-served by maintaining its floating exchange rate regime, including as an adjustment mechanism to external shocks

### Exchange rate policy and competitiveness
- The floating exchange rate regime is recommended to remain in place to serve as an adjustment mechanism to external shocks.
- Mexico’s real exchange rate is facing opposing forces: rising external competition (which would tend to induce a weaker rate) versus the surging oil price—and the additional domestic demand it supports—which would induce real appreciation.
- Non-oil exports are still growing, though only modestly.
- If signs were to emerge suggesting that price competitiveness were deteriorating excessively, fiscal policy could be called upon to reduce the public sector’s contribution to demand.

### Near-term and medium-term growth outlook
- Near-term: Mexico’s growth outlook will continue to be closely linked to global and, in particular, U.S. developments, which are expected to remain relatively favorable. With the passing of mainly sector-specific factors that led to disappointing growth in the first half of this year, and barring important surprises in the global environment, Mexico’s growth is likely to soon return to a moderate pace.
- Medium-term: Lifting Mexico’s growth trend will depend mainly on the performance of the country’s own economic policies. External competitiveness faces ongoing challenges from rising competition from China and other countries, requiring movement up the production ladder to raise trend productivity and growth.
- Baseline medium-term projections (selected):
  - Real GDP: 2005 = 3.0; 2006 = 3.5; 2007 = 3.1; 2008 = 3.1; 2009 = 3.1; 2010 = 3.1 (annual percentage change).
  - Consumer prices (end of year): 2005 = 3.9; 2006 = 3.4; 2007 = 3.0; 2008 = 3.0; 2009 = 3.0; 2010 = 3.0 (annual percentage change).
  - Current account balance (percent of GDP): 2005 = -1.1; 2006 = -0.7; 2007 = -1.1; 2008 = -1.3; 2009 = -1.4; 2010 = -1.6.
  - Projection assumption: “Projection assumes fiscal policy will target and achieve an augmented deficit of about 1 1/2 percent of GDP, from 2006.”

### Structural reform agenda and policy implications
- Raising trend productivity and growth requires advancing the pending structural reform agenda.
- The pending structural reform agenda includes reforms in:
  - the energy and telecommunications sectors,
  - the labor market,
  - the judicial system,
  - the tax system,
  - regulatory and business environments.
- Progress on structural reforms has been disappointing overall, though there has been progress in some areas, especially the financial sector.
- Without significant new breakthroughs on this agenda, the likelihood is that Mexico may achieve only lackluster economic growth.
- Political note: It is hoped the political system will find a way forward on reforms that so far have met gridlock; some analysts expect the natural development of new working relationships and rules of the game will improve prospects for consensus on new reforms.

### Fiscal policy stance and recommendations
- Fiscal policy is highlighted as the tool to curb domestic demand if excessive loss of price competitiveness emerges (i.e., reduce the public sector’s contribution to demand).
- Staff projections and public finance indicators (selected):
  - Augmented balance (nonfinancial public sector, percent of GDP): 2005 = -2.3; Projection 2006 = -1.4.
  - Augmented primary balance (percent of GDP): 2005 = 1.4; Projection 2006 = 2.2.
  - Budgetary revenue (percent of GDP): 2005 = 23.2; 2006 (staff projection) = 21.3.
  - Budgetary expenditure (percent of GDP): 2005 = 23.4; 2006 (staff projection) = 22.8.
  - Gross public sector debt (percent of GDP): 2004 = 46.5; 2005 = 45.3; 2006 (staff projection) = 43.4.

### Recommendation for surveillance
- It is recommended that the next Article IV consultation with Mexico be held on the standard 12-month cycle.

*Source: IMF staff report content (selected paragraphs and tables).*

### 1. Eradicate extreme

### _cr05427 - 1. Eradicate extreme

### 1. Millennium Development Goals — key indicators and targets
- Goal 1: Eradicate extreme poverty and hunger
  - 2015 target = halve 1990 $1 a day poverty and malnutrition rates
  - Population below $1 a day (%): ..  ..  9.9 ..
  - Poverty gap at $1 a day (%): ..  ..  3.7 ..
  - Percentage share of income or consumption held by poorest 20%: ..  ..  3.1 ..
  - Prevalence of child malnutrition (% of children under 5): 16.6 16.9 7.5 ..
  - Population below minimum level of dietary energy consumption (%): 5.0 5.0 5.0 5.0

- Goal 2: Achieve universal primary education
  - 2015 target = net enrollment to 100
  - Net primary enrollment ratio (% of relevant age group): 95.6 99.5 99.4 ..
  - Percentage of cohort reaching grade 5 (%): 79.5 89.0 90.5 ..
  - Youth literacy rate (% ages 15-24): 95.2 96.2 96.6 ..

- Goal 3: Promote gender equality
  - 2005 target = education ratio to 100
  - Ratio of girls to boys in primary and secondary education (%): 98.4 98.2 101.3 ..
  - Ratio of young literate females to males (% ages 15-24): 94.7 98.8 99.7 97.4
  - Share of women employed in the nonagricultural sector (%): 35.4 35.9 37.3 37.1
  - Proportion of seats held by women in national parliament (%): 12.0 14.0 18.0 16.0

- Goal 4: Reduce child mortality
  - 2015 target = reduce 1990 under 5 mortality by two-thirds
  - Under 5 mortality rate (per 1,000): 44 36 30 25
  - Infant mortality rate (per 1,000 live births): 37 30 25 23
  - Immunization, measles (% of children under 12 months): 75 90 96 96

- Goal 5: Improve maternal health
  - 2015 target = reduce 1990 maternal mortality by three-fourths
  - Maternal mortality ratio (modeled estimate, per 100,000 live births): 89 .. 8365
  - Births attended by skilled health staff (% of total): .. 85.7 .. ..

- Goal 6: Combat HIV/AIDS, malaria and other diseases
  - 2015 target = halt, and begin to reverse, AIDS, etc.
  - Prevalence of HIV, female (% ages 15-24): ..  ..  0.1 ..
  - Contraceptive prevalence rate (% of women ages 15-49): ..  65 70 ..
  - Number of children orphaned by HIV/AIDS: ..  ..  27,000 ..
  - Incidence of tuberculosis (per 100,000 people): 49.0 43.6 36.5 33.5
  - Tuberculosis cases detected under DOTS (%): .. 15.2 68.2 80.9

- Goal 7: Ensure environmental sustainability
  - 2015 target = various (see notes)
  - Forest area (% of total land area): 32.2 .. 28.9 ..
  - Nationally protected areas (% of total land area): 2.9 3.7 3.5 9.1
  - GDP per unit of energy use (PPP $ per kg oil equivalent): 5.1 5.3 5.8 5.6
  - CO2 emissions (metric tons per capita): 3.7 4.3 4.3 ..
  - Access to an improved water source (% of population): 80 .. 88 91
  - Access to improved sanitation (% of population): 66 .. 74 77
  - Access to secure tenure (% of population): ..  ..  ..  ..

- Goal 8: Develop a Global Partnership for Development
  - 2015 target = various (see notes)
  - Youth unemployment rate (% of total labor force ages 15-24): 5.4 7.1 4.4 4.9
  - Fixed line and mobile telephones (per 1,000 people): 65.6 101.2 267.1 448.8
  - Personal computers (per 1,000 people): 8.2 25.6 57.6 82

- Notes (selected goals): 
  - Goal 1 targets: Halve, between 1990 and 2015, the proportion of people whose income is less than one dollar a day. Halve, between 1990 and 2015, the proportion of people who suffer from hunger.
  - Goal 2 target: Ensure that, by 2015, children everywhere, boys and girls alike, will be able to complete a full course of primary schooling.
  - Goal 3 target: Eliminate gender disparity in primary and secondary education preferably by 2005 and to all levels of education no later than
  - Goal 4 target: Reduce by two-thirds, between 1990 and 2015, the under-five mortality rate.
  - Goal 5 target: Reduce by three-quarters, between 1990 and 2015, the maternal mortality ratio.
  - Goal 6 targets: Have halted by 2015, and begun to reverse, the spread of HIV/AIDS. Have halted by 2015, and begun to reverse, the incidence of malaria and other major diseases.
  - Goal 7 targets: Integrate the principles of sustainable development into country policies and programs and reverse the loss of environmental resources. Halve, by 2015, the proportion of people without sustainable access to safe drinking water. By 2020, to have achieved a significant improvement in the lives of at least 100 million slum dwellers.
  - Goal 8 targets: Develop further an open, rule-based, predictable, non-discriminatory trading and financial system. Address the Special Needs of the Least Developed Countries. Address the Special Needs of landlocked countries and small island developing states. Deal comprehensively with the debt problems of developing countries through national and international measures in order to make debt sustainable in the long term. In cooperation with developing countries, develop and implement strategies for decent and productive work for youth. In cooperation with pharmaceutical companies, provide access to affordable, essential drugs in developing countries. In cooperation with the private sector, make available the benefits of new technologies, especially information and communications.

### II. Mexico — Fund relations and financial arrangements (as of August 31, 2005)
- Membership Status: Joined December 31, 1945; Article VIII.
- General Resources Account:
  - Quota: 2,585.80 SDR Million, 100.00% Quota
  - Fund holdings of currency: 1,954.89 SDR Million, 75.60%
  - Reserve position in Fund: 630.96 SDR Million, 24.40%
- SDR Department:
  - Net cumulative allocation: 290.02 SDR Million, 100.00%
  - Holdings: 308.04 SDR Million, 106.21%
- Outstanding Purchases and Loans: None
- Latest Financial Arrangements:
  - Stand-by: Approval Jul 07, 1999; Expiration Nov 30, 2000; Amount Approved 3,103.00 SDR Million; Amount Drawn 1,939.50 SDR Million
  - Stand-by: Approval Feb 01, 1995; Expiration Feb 15, 1997; Amount Approved 12,070.20 SDR Million; Amount Drawn 8,758.02 SDR Million
  - EFF: Approval May 26, 1989; Expiration May 25, 1993; Amount Approved 3,729.60 SDR Million; Amount Drawn 3,263.40 SDR Million
- Projected Payments to the Fund (Forthcoming):
  - 2005: Principal 0.0; Charges / Interest 0.02; Total 0.0 0.02
  - 2006: Principal 0.0; Charges / Interest 0.02; Total 0.0 0.02
  - 2007: Principal 0.0; Charges / Interest 0.02; Total 0.0 0.02
  - 2008: Principal 0.0; Charges / Interest 0.02; Total 0.0 0.02
  - 2009: Principal 0.0; Charges / Interest 0.02; Total 0.0 0.02
- Exchange Rate Arrangement: Mexico has a floating exchange rate regime since December 22, 1994. Mexico maintains an exchange system that is free of restrictions on the making of payments and transfers for current international transactions.
- Article IV Consultation: The last Article IV consultation was concluded by the Executive Board on September 27, 2004. The relevant staff report was IMF Country Report No. 04/419.
- Technical Assistance:
  - National Accounts Mission STA May 2005
  - Payments Systems MFD December 2004
- Resident Representative: None.

### III. Statistical issues and data quality
- Overall assessment:
  - Comprehensive economic data are available on a timely basis and are adequate to conduct surveillance.
  - Core statistical data are published on a timely basis and are of good quality.
  - Mexico observes the Special Data Dissemination Standards (SDDS); metadata are posted on the DSBB.
- Data ROSC:
  - A data ROSC mission occurred February/March 2002; report published June 2003 as IMF Country Report No. 03/150.
  - Main conclusion: overall quality of Mexican statistics is good; periodicity and timeliness often exceed SDDS requirements; areas for improvement identified.
- Specific statistical issues:
  - Balance of payments: some series conform to the fifth edition of the Balance of Payments Manual, but full transition not completed.
  - IIP statistics: produced yearly.
  - External debt: improvements include compilation of external liabilities of publicly traded companies (external debt outstanding, annual amortization schedule for next four years broken down by maturity and type of instrument); projection of total external debt service of commercial banks still not available.
  - International reserves: compiled according to the Data Template on International Reserves and Foreign Currency Liquidity.
  - National accounts: follow-up mission May 2005 found incomplete capture of non-observed activities and extensive use of outdated coefficients from base year 1993; technical assistance might be needed for changing the base year, compiling an input-output table for 2003, and completing implementation of the 1993 SNA.
  - Fiscal data: since 2001 authorities report Public Sector Borrowing Requirement, encompassing direct net cost of PIDIREGAS and interest cost on previously unrecorded government liabilities; preliminary data available with a 45-day lag each quarter; final data available mid-year following year.

### IV. Relations with the World Bank (summary)
- World Bank Country Partnership Strategy (CPS) discussed April 2004 built on four pillars: (1) reduce poverty and inequality; (2) increase competitiveness; (3) strengthen institutions; (4) promote environmental sustainability.
- CPS FY05–FY08 focus: selective IBRD and IFC operations, analytical and learning services, greater role as knowledge institution, support for local governments.
- Bank exposure and portfolio (as of July 31, 2005):
  - IBRD exposure in Mexico: US$9.1 billion, representing 8.5 percent of the IBRD’s total portfolio; Mexico is the second largest borrower.
  - Portfolio under implementation: 17 lending operations for US$2.9 billion in commitments, of which US$1.6 billion are still available for disbursements.
  - Bank manages 6 full-size GEF/PCF operations (largest GEF portfolio in the Bank).
- Lending program: a lending range of US$0.8 to US$1.7 billion a year over the CPS period.
- IFC strategy: support business environment improvements via investment and advisory assistance across a spectrum of firms and reimbursable advisory services to authorities.

### V. Table of common indicators required for surveillance (memo items, as of September 15, 2005)
- Exchange Rates: Date of latest observation 9/14/05; Date received 9/15/05; Frequency of data D; Frequency of reporting D; Frequency of publication D.
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation July 2005; Date received Aug. 2005; Frequency M; Frequency of reporting M; Frequency of publication M.
- Reserve/Base Money: Date of latest observation Aug. 2005; Date received Sep. 2005; Frequency M; Frequency of reporting D, M; Frequency of publication W.
- Broad Money: Date of latest observation July 2005; Date received Aug. 2005; Frequency M; Frequency of reporting M; Frequency of publication M.
- Central Bank Balance Sheet: Date of latest observation Sep. 2005; Date received Sep. 2005; Frequency W; Frequency of reporting W; Frequency of publication W.
- Consolidated Balance Sheet of the Banking System: Date of latest observation July 2005; Date received Aug. 2005; Frequency M; Frequency of reporting M; Frequency of publication M.
- Interest Rates: Date of latest observation 9/14/05; Date received 9/15/05; Frequency D; Frequency of reporting D; Frequency of publication D.
- Consumer Price Index: Date of latest observation July 2005; Date received Aug. 2005; Frequency Bi-W; Frequency of reporting Bi-W; Frequency of publication Bi-W.
- Revenue, Expenditure, Balance and Composition of Financing – General Government: Date of latest observation July 2005; Date received Sep. 2005; Frequency M; Frequency of reporting M; Frequency of publication M.
- Stocks of Central Government and Central Government-Guaranteed Debt: Date of latest observation June 2005; Date received Aug. 2005; Frequency Q; Frequency of reporting Q; Frequency of publication Q.
- External Current Account Balance: Date of latest observation Q2 2005; Date received Aug. 2005; Frequency Q; Frequency of reporting Q; Frequency of publication Q.
- Exports and Imports of Goods and Services: Date of latest observation July 2005; Date received Aug. 2005; Frequency M; Frequency of reporting M; Frequency of publication Bi-W.
- GDP/GNP: Date of latest observation Q2 2005; Date received Aug. 2005; Frequency Q; Frequency of reporting Q; Frequency of publication Q.
- Gross External Debt: Date of latest observation June 2005; Date received Aug. 2005; Frequency M; Frequency of reporting M; Frequency of publication M.
- Footnotes: Definitions of frequencies (D, W, M, Q, A, I, NA) and assessments of methodological soundness and accuracy are provided in the source.

### VI. Debt Sustainability Analysis (2005–2010) — standardized stress-test findings
- Overall conclusion:
  - Standardized stress tests suggest Mexico’s overall resilience to plausible shocks.
- Fiscal and public debt scenarios:
  - Tests based on historical volatility of key macroeconomic variables for the past 10 years indicate public debt would not increase substantially over the medium-term under significantly worse macro conditions.
  - Worst cases considered include real GDP growth of 1.2 percent or real interest rates of 8 percent on average in the next four years; under these, public debt as a share of GDP would remain in the 48-50 percent range.
  - Currency depreciation does not pose a serious fiscal risk; fiscal accounts would improve if the peso were to weaken.
  - A broad range of shocks would raise the public sector financing requirement because of relatively short average maturity of domestic debt.
  - Worst projected case: economic stagnation with annual public sector financing requirements reaching 16½ percent of GDP, compared to about 13 percent in 2005.
- External position:
  - Standardized tests illustrate Mexico’s strong external position.
  - Deterioration of growth outlook or primary external current account would have limited effects on external debt and external financing requirements.
  - Most significant external shock would be a large exchange rate depreciation vis-à-vis the US dollar; even then, overall external debt would remain below 30 percent of GDP by 2010.
  - Projected increase in external debt from depreciation would be significantly offset by revaluation of net international reserves.

*Source: Mexican authorities; and World Development Indicators database; IMF staff report content as provided in the source PDF.*

### 2. Other stress scenarios

### 2. Other stress scenarios

### Fiscal impact of a sudden permanent decline in oil prices
- Assumed world average petroleum price: US$ 40 per barrel from 2006 onwards, implying less than US$30 per barrel for the Mexican oil mix.
- If only limited spending cuts are assumed:
  - Primary balance is estimated to deteriorate by about 1 percent of GDP every year.
  - Gross public debt would remain above 45 percent of GDP.
  - Financing requirements would be around 13 percent of GDP throughout the medium-term.
- The actual fiscal impact depends importantly on the administered pricing of domestic energy (gasoline and electricity) provided by state enterprises; if lower international fuel prices were transmitted to domestic consumers, the fiscal effect would be greater.
- External effect: main effect would be a reduction in the pace of reserve accumulation rather than a significant jump in the level of debt or financing requirements.

### Market-confidence (financial liquidity) shock
- Scenario: arbitrary shock to market confidence in Mexican assets, implying a financial liquidity test with:
  - rapid deterioration of the exchange rate,
  - a hike in interest rates,
  - a return to short-term or interest-rate indexed debt as the principal means to finance the fiscal deficit and public debt falling due.
- Staff findings (using magnitudes observed in recent crisis episodes outside Mexico):
  - The fiscal deficit would not show a marked deterioration.
  - There would be a substantial rise in short-term financing requirements, which could cause further deterioration of confidence and additional financial pressures on the public sector.
  - The external position would not deteriorate significantly.

### U.S. "hard-landing" scenario
- Features: sudden economic stagnation in the United States, higher domestic interest rates in Mexico, some peso appreciation against the dollar, and declining remittances and oil export prices.
- Outcome:
  - Confirms the same sources of potential vulnerability (oil and interest rate shocks, liquidity pressures).
  - Smaller growth of the public financing requirement than in the market-confidence shock.
  - Oil and interest rate shocks would cause a widening of the fiscal deficit, which could undermine confidence in public debt if not met with clear fiscal policy response.

### Baseline projections (selected indicators from Tables)
- Public sector gross debt (percent of GDP):
  - 2000: 49.3
  - 2005: 45.3
  - 2006: 43.4
  - 2010: 40.1
- o/w foreign-currency denominated (percent of GDP):
  - 2000: 16.1
  - 2005: 15.2
  - 2010: 11.3
- Change in public sector debt (percent of GDP):
  - 2005: -1.2
  - 2006: -1.9
  - 2010: -0.7
- Primary deficit (percent of GDP):
  - 2005: -1.5
  - 2006: -2.3
  - 2010: -1.9
- Revenue and grants (percent of GDP):
  - 2005: 23.1
  - 2010: 22.2
- Primary (noninterest) expenditure (percent of GDP):
  - 2005: 21.6
  - 2010: 20.3
- Gross financing need (percent of GDP and in billions of U.S. dollars):
  - 2005: 13.0 percent of GDP; 98.6 in billions of U.S. dollars
  - Baseline projections 2006–2010 (percent of GDP): 12.5, 12.4, 11.9, 11.7, 11.4
  - Baseline projections 2006–2010 (in billions of U.S. dollars): 103.2, 107.5, 108.9, 112.8, 116.1

### Selected stress-test scenario outcomes (gross financing need)
- Public sector (percent of GDP) — Alternative scenarios (2006–2010):
  - A1. Key variables at historical averages in 2006-10: 13.0, 10.5, 8.9, 7.8, 6.9, 6.1
  - A2. No policy change (constant primary balance) in 2006-10: 13.0, 13.4, 13.3, 13.0, 12.9, 12.8
  - A3. International oil prices at US$40 per barrel: 13.0, 14.2, 13.9, 13.5, 13.2, 12.9
- Public sector (in billions of U.S. dollars) — Alternative scenarios (2006–2010):
  - A1. Key variables at historical averages: 98.5, 86.0, 76.2, 70.5, 65.7, 60.5
  - A2. No policy change: 98.5, 110.8, 115.6, 118.8, 124.2, 129.5
  - A3. International oil prices at US$40: 98.5, 116.7, 120.5, 123.1, 127.4, 130.9
- External (gross external financing need in billions of U.S. dollars) — Alternative scenarios:
  - Baseline 2005: 51.3
  - A1. Key variables at historical averages in 2006-10: 51.3, 52.9, 53.3, 48.0, 40.8, 31.2
  - A2. Falling international oil prices: 51.3, 61.1, 74.5, 81.7, 88.8, 97.7
- External (gross external financing need, percent of GDP) — Alternative scenarios:
  - A1. Key variables at historical averages in 2006-10: 6.8, 6.6, 6.3, 5.4, 4.3, 3.1
  - A2. Falling international oil prices: 6.8, 7.4, 8.6, 8.9, 9.2, 9.6

### Stress-test diagnostics and bound tests (high-level)
- Individual permanent one-half standard deviation shocks analyzed include:
  - Real interest rate shock
  - Real GDP growth shock
  - Primary balance shock
  - Real depreciation (one-time 30 percent in 2006) and contingent-liabilities shocks (10 percent of GDP)
- Combined shocks and bound tests show materially higher gross financing needs under combinations of adverse shocks; specific scenario outcomes are reported in the tables above and the associated figures.

*Source: _cr05427 - 2. Other stress scenarios*

### 1.      Recent indicators suggest that, as expected, economic activity recovered

### _cr05427 - 1.      Recent indicators suggest that, as expected, economic activity recovered

### Economic activity and growth
- Third quarter 2005: indicators suggest economic activity recovered somewhat; recent hurricanes (Stan and Wilma) could impact growth at the end of the year.
- Bank of Mexico (BoM) projects growth of 2¾ to 3¼ percent for 2005.
- IMF staff projection: 3 percent for 2005, assuming a pickup in growth in the second half of the year.
- Activity indicators:
  - Index of overall economic activity: rose by 4.5 percent in August year-over-year.
  - Retail sales: grew by 4.4 percent in real terms (August).
  - September industrial production: showed almost no growth from a year earlier.
- BoM assessment of hurricane impact: expects their effect on GDP growth will be small.
- Broader context from PIN:
  - Recovery began in mid-2003 and continued through 2004 (growth 4.4 percent in 2004).
  - First semester 2005 growth slowed to 2.8 percent.
  - Most recent indicators point to strengthening of activity in the third quarter of 2005.

### Inflation and wages
- Headline inflation (12-month basis):
  - Just under 4 percent in August 2005.
  - 3.5 percent in September 2005.
  - 3.1 percent in the first half of October 2005.
  - IMF staff report projection for end-2005 headline inflation: 3.9 percent.
  - BoM revised its end-2005 inflation projection from just under 4 percent to about 3½ percent.
  - PIN notes headline inflation peaked at 5.4 percent in November 2004 and declined to 3.1 percent in the first half of October 2005.
- Core inflation: edged down to 3.2 percent in the first half of October 2005.
- Contractual wages: increases remain around 4½ percent (September data).
- Risks noted: potential agricultural price shocks from recent hurricanes, but recent developments suggest end-2005 headline inflation likely below the staff projection of 3.9 percent.

### Monetary policy and interest rates
- October 28, 2005: BoM announced a 25 basis point easing of monetary conditions; overnight interbank rate declined from 9¼ to 9 percent.
- This was the third 25 basis point easing since monetary easing began at end-August 2005, with no change in the corto.
- BoM will shift to monthly policy meetings from twice monthly, linked to greater inflation stability and predictability.
- PIN monetary context:
  - BoM tightened policy from early 2004, raising the overnight interbank interest rate from less than 5 percent in early 2004 to 9 ¾ percent by spring 2005.
  - Since August 2005, rates came down to 9 percent, with 25 basis point cuts signaled in each of August, September, and October 2005.
  - BoM has signaled a desired minimum level of interest rates while maintaining the corto instrument (the borrowed reserves objective).

### External sector and trade
- Third quarter 2005 trade data:
  - Value of total exports (U.S. dollars): grew 13½ percent in the third quarter (compared to 11 percent in the first semester).
  - Non-oil exports: grew 9½ percent in the third quarter (compared to 8¼ percent in the first semester).
  - Value of imports: continued to grow at an annual rate of about 12 percent, about the same rate as in the first six months of the year.

### Fiscal developments and 2006 budget
- 2005 budget dispute: remaining dispute resolved in late October 2005; deputies and executive agreed on composition of spending for 2005.
- 2006 budget process: discussions expected to be completed by November 15 (year implied by text).
- House of deputies actions on 2006 budget (as reported):
  - Approved a revenue law that would allow budgeted spending to be about 1 percent of GDP higher than in the government’s proposal.
  - Changes implemented by deputies:
    - Raised the budget’s oil price assumption from $31.5 to $36.5 per barrel.
    - Raised projected non-oil revenue.
    - Lowered the fiscal balance target from a small surplus to balance (traditional definition).
  - Staff assessment: changes do not imply a significant revision of staff report’s projections of the overall fiscal balance in 2006; staff continue to expect that the non-oil augmented balance will be broadly unchanged from 2005.
- Fiscal outcomes and projections (PIN and staff):
  - 2004: traditional deficit achieved target of 0.3 percent of GDP; augmented deficit narrowed to 2 percent of GDP from 3.1 percent in 2003.
  - Gross public debt declined to 46.5 percent of GDP (2004), partly through write-off of some bank restructuring debt.
  - 2005: oil revenues rising again, but deterioration in the non-oil fiscal balance more than offsets this.
  - Staff project traditional deficit will narrow slightly to 0.2 percent of GDP in 2005; augmented deficit is projected to widen in 2005 (text cuts off before final augmented deficit figure).

### Financial sector and FSAP
- The Mexican authorities officially requested an FSAP update; work to begin early next year (as reported in the text).

### IMF Executive Board and Public Information Notice
- Public Information Notice (PIN) No. 05/160, FOR IMMEDIATE RELEASE December 1, 2005.
- IMF Executive Board concluded the 2005 Article IV consultation with Mexico on November 9, 2005.
- Article IV context: staff mission visits, staff report prepared, Executive Board discussion concludes with Managing Director summarizing views for the country's authorities.

*Source: _cr05427 - 1.      Recent indicators suggest that, as expected, economic activity recovered*

### 2.3 percent of GDP. Oil income for the year is projected to be up by about ½ percentage point

### _cr05427 - 2.3 percent of GDP. Oil income for the year is projected to be up by about ½ percentage point

### Fiscal developments and oil revenue
- Oil income for the year is projected to be up by about ½ percentage point of GDP from 2004 (and about 1 percentage point over budget projections).
- Almost all unbudgeted oil revenue is expected to:
  - compensate for shortfalls in non-oil revenue;
  - finance transfers for additional investment spending by PEMEX and the states (as implied by the budget law).
- A small part of excess oil revenue will go to:
  - the oil stabilization fund; and
  - reduction of the traditional budget deficit.
- Authorities presented a conservative budget including a 0.2 percent of GDP surplus for 2006.
- During the current administration:
  - the traditional balance has been reduced from 1.1 percent of GDP in 2000 to an expected 0.2 percent of GDP in 2005 and to an equilibrium or even a surplus in 2006;
  - the augmented deficit will decrease from 3.7 percent of GDP to 2.4 percent in 2005 and to 1.5 percent in 2006.
- Public sector internal absorption of resources (public sector borrowing requirements as a share of domestic financial savings) decreased from 66 percent in 2000 to an estimated 14 percent in 2005.
- Net external debt is expected to be equivalent to 6.8 percent of GDP at end 2006.
- Expected average net financing cost of the federal government for 2001-2006: near 2.5 percent of GDP (0.8 percentage points lower than the previous administration).
- Average maturity of domestic debt increased from 291 days in 1993, to 539 in 2000, to 1,161 in September 2005; 37 percent of total debt is short term, compared to 65 percent in 2001.

### External sector and reserves
- External current account deficit remained modest.
- Rise in oil exports and household remittances helped compensate for some widening of the non-oil trade deficit.
- Imports of investment and especially consumer goods grew strongly with recovery in 2004 and 2005.
- Weak auto exports to the U.S. and enhanced competition from China and other countries slowed non-oil exports.
- Net international reserves (NIR):
  - reached US$61 billion by end 2004 (about 4½ months of Mexico’s imports and 1.6 times its short-term external liabilities);
  - at October 28, 2005, NIR was US$62.3 billion.
- At mid-year authorities announced federal government had accumulated enough foreign currency liquidity to forego any external bond issues through 2007.

### Financial markets and banking sector
- Sovereign bond spreads declined, recently to less than 150 basis points.
- At end-October (2005), the stock market was up more than 75 percent (in domestic currency terms) since end-2003, with much of the gain since April 2005.
- The peso strengthened during the year though gave up some gains since August 2005.
- Bank of Mexico (BoM) has abstained from market purchases of foreign exchange; rising oil foreign exchange receipts pushed NIR upward.
- Financial sector improvements:
  - commercial banks appear well capitalized, profitable, and provisioned against nonperforming loans;
  - bank credit has begun to expand after a long period of stagnation;
  - between 2001 and 2004 more than 20 initiatives to develop the financial system and improve efficiency were approved.
- Domestic financial savings increased from 42.4 percent of GDP in 2000 to 51.0 percent in 2005.
- Financing to the private sector rose from 17.9 percent of GDP in 2000 to 22.7 percent in March 2005.
- Authorities requested a FSAP update to assess reforms and identify further opportunities in the financial sector.
- Authorities working with Congress on a new Securities Market Law to improve legal framework for companies in the stock market.

### Monetary policy and inflation
- Monetary tightening of 2004 and early 2005 deemed necessary to contain inflation and reverse inflation expectations.
- Headline and core inflation are now close to the 3 percent target.
- Inflation target: long-term target of 3 percent with a variability range of +- 1 percentage point (announced in 2002).
- Improved inflation outlook allowed the Bank of Mexico to begin gradually loosening policy stance; Directors recommended proceeding cautiously as inflation expectations have not yet converged to the 3 percent target.
- Changes in BoM operational framework since early 2004:
  - refocused policy statements;
  - BoM provides an indication of its estimate of inflation for the current year;
  - shift toward defining policy changes through signalling a minimum level of interest rates.
- Some Directors suggested publishing inflation forecasts for both the current year and a somewhat longer horizon and adopting fully an interest rate policy instrument.

### IMF Executive Board assessment and policy recommendations
- Executive Directors commended Mexico for improvements in economic policies, institutions, and structures contributing to macroeconomic stability and reduced financial vulnerability.
- Fiscal policy commended for achieving annual deficit targets and improving debt structure; Directors encouraged continuation of these efforts.
- Directors warned that the overall fiscal balance is increasingly dependent on rising world oil prices; a reversal could complicate fiscal policy if expenditures could not be reduced quickly.
- Most Directors urged avoiding a further widening of the non-oil fiscal deficit in 2006; a few recommended close monitoring of increased state government spending.
- Directors supported Mexico’s intention to implement a medium-term budget framework with objectives to:
  - reduce public debt further;
  - strengthen public finances;
  - limit vulnerability to oil revenue fluctuations;
  - allocate resources efficiently to essential investments, especially in the oil and social sectors.
- Directors encouraged measures to strengthen and broaden the tax system and bring more of the economy into the formal sector.
- Directors emphasized the need for more thoroughgoing structural reforms, including in:
  - the energy and telecommunications sectors;
  - the labor market;
  - the judicial system;
  - the tax system;
  - the regulatory and business environment.
- Directors welcomed progress in strengthening and reforming the financial sector and capital markets and reducing potential vulnerabilities, while expressing disappointment at the slow pace of broader structural reforms.
- Directors considered the floating exchange rate regime appropriate and judged external competitiveness to be broadly adequate.

### Structural reform priorities (authorities' stance)
- Authorities committed to pursue consensus for approving structural reforms to boost productivity and sustain growth.
- Structural reform areas highlighted for priority:
  - financial, labor, and fiscal areas;
  - reducing regulation and fighting monopolies;
  - opening up competition in energy and telecommunications.
- Authorities recognize need to allocate excess oil revenue to:
  - investment in the oil sector (PEMEX);
  - infrastructure projects in the states;
  - improving the public balance; and
  - the oil stabilization fund.
- Authorities submitted an initiative to reform the Budget Process, including a Fiscal Responsibility Law, with rules to set the oil price in the budget and provisions for the oil stabilization fund.

*Source: IMF country report content provided in the supplied PDF excerpt.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05427.pdf_